In the wake of the holidays, it’s the time of year many of us are trying to hold to our resolutions and are thinking about taxes. One resolution of mine was to write more often about interesting legal issues that come up in my practice and since I worked on several deals involving 1031 exchanges last year this quick article seems an appropriate way to kick off a year of active blogging.
Deferring capital gains by proper application of IRC section 1031 is nothing new to real estate investors or real estate attorneys. A twist arises when exchanging sales proceeds into property owned by multiple persons as a tenancy in common (TIC), an ownership structure were multiple owners each acquire an undivided fractional interest in property. In Colorado, TIC is the default ownership when multiple parties own real estate unless the conveyance deed states otherwise (Joint Tenancy is usually preferable for married couples). Most arms-length TIC owners execute a Tenancy In Common Agreement specifying rights and duties of the owners, governing management of the commonly owned property, financial obligations of the owners, establishing transfer restrictions and other rules the owners are bound by. Such an arrangement sounds similar to a limited liability company – so, why not execute an LLC Operating Agreement and invest sales proceeds in an LLC?
To qualify for exchange treatment under section 1031 the property sold and the replacement property must be “like kind” and according to the IRS, membership interests in an LLC (or shares in a corporation) aren’t similar similar enough to real property held for investment. So, rolling proceeds into TIC owned property allows one to invest in a property with multiple co-owners outside of an LLC and qualify for exchange treatment under section 1031. This enables a seller to invest their proceeds into larger and more sophisticated properties with greater potential ROI. Since TIC structures can be similar to partnerships and LLCs, the IRS issued Revenue Procedure 2-2022 outlining requirements TIC structures to qualify for 1031 treatment. The revenue procedure establishes 15 conditions and standards for investments in TIC structures to qualify for exchange treatment. One simple condition is that there may not be more than 35 TIC owners. Another condition is that property management agreements must renew at least annually and while the manager may be a co-owner of the TIC property, they may not be a tenant. Additionally, TIC agreements should require unanimous consent for decisions that will impact the property economically or which result in any other material impact on the property.
When sellers want to roll proceeds into a TIC interest in a property, the TIC Agreement, Property Management Agreement, LLC Operating Agreement (where the TIC interest is to be owned by an LLC) and all other material agreements among TIC owners related to the property bear close scrutiny to confirm the exchange qualifies for section 1031 treatment.
Thanks for reading & happy new year! Good luck with those resolutions…